“Wall Street” is All of Us

It’s easy to see this week’s events around GameStop and the stand-off between individual investors and hedge funds as a welcome shift in our investment universe. But a desire to tear down systems before we know what will replace them is bad for all of us. Impact investments may offer an interim solution.

There has been a lot of buzz this week about the news-making clash between a group of Reddit-organized individual investors and their siege on the investment industry — hedge funds in particular. The latest scuffle follows a long list of examples of individuals squaring off against systems that they can’t access, feel are self-serving, or built for and by the wealthiest and most privileged among us.

Cancel culture — the practice of effectively ending the career of an individual or organization by revoking their cultural cachet through boycotts of their work, disciplinary actions from peers or employers, or a mass exodus of paying customers — dominates much of the technology-inspired “activism” we see today. As the NYT’s Kevin Roose points out in his commentary on this week’s events, very few systems have escaped the stampede-like wave of cancellation in the last 18 months. The latest and most seismic outcome of banding together to terminate systems as we know them — online and in mob form — resulted in a literal insurrection on the U.S. Capitol earlier this year.

It is far too simplistic — and just plain wrong — to read the latest coordinated incursion on Wall Street as a more palatable example of “sticking it to the man.” A blatant misunderstanding of how the capital markets work, who hedge funds ultimately serve, and the danger of burning down a system before thinking about how to replace it, has resulted in a short-sighted set of cosmetic decisions that have the potential to hurt more of us than the Robin Hoods of Robinhood realize.

For those of us that are working to repurpose the capital markets into a force for good, this kind of activity feels like a step in the wrong direction. In truth, the winners and losers of a market-based system are all of us. There is much work we need to do to remake the investment system of yesterday, and yes, sometimes those shifts seem incremental and slow. But vigilante-fueled disruption will not get us to a more ideal version of a world that truly serves all of us. It will leave us without the infrastructure needed to inspire real, meaningful change.

To truly understand the events of this last week, it might help to start with a recap of what hedge funds are, what they do, and who actually uses them.

A Quick Overview of Hedge Funds

A hedge fund is an investment vehicle that trades in (relatively) liquid assets, using a range of complex investment techniques that help maximize returns. Hedge funds are often referred to as a separate asset class — nestled somewhere between the wholly available public markets and the traditionally unavailable private markets. Since they often trade publicly listed securities, but are only available to the highly accredited, their grey-area status makes some sense. For others, hedge funds are nestled firmly in the private markets and within alternative investment strategies, signalling their relatively inaccessible status across investment products. This positioning might be our first mistake. Hedge funds are more of an investment structure than they are their own asset class. Hedge funds are formed through an investment partnership, often through pooled funds, that have extreme freedom in how they buy, sell, and trade securities (more than your traditional mutual fund.)

Hedge funds were designed — and are still used by many investors — for three key reasons: increased liquidity (the ease with which an asset can be converted to cash without serious price implications), outsized returns (more upside), and diversification (mixing a variety of unconnected investments into your portfolio).

Hedge funds utilize two investment practices (among many others) that create some serious fury in our living rooms and even some boardrooms: speculation and hedging. Speculation is what it sounds like — a financial transaction based on sophisticated guesswork that has the potential to realize massive losses and massive gains. Hedging is a more ubiquitous investment practice that involves assuming counter-positions across your portfolio to reduce risk (in other words betting on all potential outcomes in case the markets go completely haywire, positively or negatively: like in 2008, 2009, 2020, etc.)

Hedging is a very routine investment practice, and in many investment disciplines, an important tactic to protect yourself against volatility in your portfolio. The primary objective of hedging is protection (vs. the profit motivation of speculation.) We know that markets are unpredictable.

For all the talk about the rationality of supply and demand that sets the terms of the market, the consumers of that information and vehicles for making those decisions — us, the humans — are emotional and often irrational when it comes to making investment decisions. We work symbiotically with those markets — extracting and sharing information and acting on what we learn and know. When those markets react unpredictably (either because of us or in spite of us), hedges offer counter-bets on many of the trends that investors expect. They help ensure that even in the unhoped for outcome, they can generate adequate returns to cover their losses. To hedge effectively, investors seek uncorrelated assets. Correlation is a statistical measure that determines how assets move in relation to each other. To effectively hedge, investors seek to build portfolios based on uncorrelated investments — investments that are unaffected by the movement of each other. It is a tool to build diversification and a key tenant of modern portfolio theory (MPT.)

Speculation, on the other hand, frustrates many investors. Much of the reason why speculation is so poorly regarded is because one way of doing it relies on the failure of others — the eventual decline of the stock price of a security (or a set of securities.) This expectation is called short selling — or shorting — stocks. In short selling, an investor borrows the shares of a stock that they believe will decrease in value by a set future date. Borrowing shares is not so dissimilar to a traditional loan:

• Investors borrow shares (usually from a broker) for a duration up to 12 months.
• At the end of the loan period, the investor has to return the stocks.
• Just as in a traditional loan,the investor has to pay interest to the loaning broker while they use those stocks.
• The key difference in this type of arrangement vs. a more traditional loan is that the broker can (typically) ask for the shares back at any time, which adds additional risk for the investor.

The investor sells those borrowed shares to other investors at their current market price. The investor does this because they believe that the current market price of the shares is as high as the stock’s value will be. By the time the shares need to be returned, the investor is betting that the price of those shares will decline. When that expiration date hits, the investor needs to return those shares to the broker. Since they’ve sold the borrowed shares, they need to replace them, and they hope they can purchase those shares at the now lower stock price. The difference between what the investor sold those borrowed shares for and what the investor bought the replacement shares for, is their profit (or, of course, loss). The risk of loss in a short sale is (theoretically) infinite — the price of that stock can climb as high as is humanly possible, and the investor must buy those stocks back at whatever their current value is by the expiration date.

As random and arbitrary as short selling sounds — and just plain dangerous — investors don’t make these bets in an entirely superfluous fashion. Hedge fund investors short stocks in order to turn a profit, based on an expectation (informed by actual expertise and experience) that:

• The stock itself is overvalued and will correct itself through the usual machinations of the market.
• There is new information available in the markets within which the stock operates, that will result in a decrease in share value.
• There is legal, regulatory or financial action that might devalue the stock.
• And most commonly, to offset long positions they also own (an equally speculative assumption that bets on the value of a share price increasing.)

So what happened with GameStop?

In essence, something called a short squeeze. A short squeeze occurs when the value of the stock begins to rise, as opposed to the investor’s expectation of the value declining. Short sellers must cover their trades by buying those short positions back — now at higher values. Remember that the investor borrowed those shares - they need to give them back to the original owner. The buying-back creates a feedback loop — demand for the shares increases and attracts more buyers, which pushes the stock price higher. And investors need to do this quickly — the higher the price rises, the larger their overall loss. The increase in the stock price causes even more short sellers to buy their shares back to cover their positions. Welcome to the investment free-for-all.

In January of this year, a short squeeze occurred on GameStop Corp (GME) thanks to efforts by a group of retail investors that colluded on Reddit and purchased shares through Robinhood (a financial services company that allows investors to “make unlimited commission-free trades in individual stocks, and options — along with ETFs and cryptocurrencies”) to drive up the value of GME stock. This resulted in a large price spike that caught short sellers (of GameStop Corp stock) unprepared and unaware — they were forced to cover their short positions at substantial losses (i.e. buy the shares back at a higher price than they sold them for).

If this is just the downside of short selling — and the risk that short sellers take on by engaging in this speculative activity— what’s the big deal? Are we actually expected to feel sorry for multi billion dollar money managers who messed up? No. But that’s also not what happened.

The important lessons in last week’s events are about how and why this happened — and not so much what happened. Here are some of the things that we think have gotten lost in the conversation - and need to be front and center:

The actions of the Price Fixers are not much better than the hedge funds that were targeted

Short sellers take on short positions based on their own insight and expertise (and sure, sometimes whims) around how stock prices will behave. The Reddit investors created an arbitrary run on a poorly performing stock. GameStop stock was already struggling and short positions on struggling companies (who are more likely to see their stock values naturally decrease) are common. There was no new material information on GameStop, the market, or any other investment-related consideration that justified such a drastic price increase. That’s very different from how hedge funds make these bets.

This felt more like anarchy. The accusation that hedge funds are niche, inaccessible and downright scandalous has serious merit to it. But if they are guilty of using their easily disposable capital and access to privileged information to seemingly manipulate the system, how are the actions of this group of investors any different?

Collusion occurs when investment rivals attempt to disrupt the market equilibrium by eschewing their usual competition against each other and conspiring to gain an unfair advantage. The group of individual investors in this story are — technically — competitors in the market, since each purchase, sale or trade decision helps determine the equilibrium price of the securities being traded. In an investment context, collusion is highly monitored and very often illegal. Banding together and driving up the price of a stock is collusion. The differences here — if any — revolve around the medium with which these investors gathered. Was this a coordinated plot or a social media conversation gone awry? If the latter, wrongdoing will be especially difficult to prove. The Securities and Exchange Commission is officially looking into it (although most of their interest has been about whether Robinhood, the platform that allowed traders to purchase GameStop securities, acted improperly by restricting trades for a range of stocks on the following days.)

The narrative that this was an ideological movement to punish hedge funds is also misrepresented. Melvin Capital, who had an outsized short position on GameStop, was specifically targeted. According to Michelle Celariar’s piece in Institutional Investor:

“The effort to take down Melvin appears to have started late last year, and by mid-January, short sellers began noticing spikes in the price of GameStop… About two months ago, a Reddit user called Stonksflyingup posted a video, with the title “GME Squeeze and the Demise of Melvin Capital” — with trial scenes from the miniseries “Chernobyl” superimposed with text asserting that “Melvin Capital got too greedy,” as well as an explanation of how a short squeeze can occur. The clip concluded with a photo of an explosion with the words “Melvin Capital” splashed across it.”

I’m not suggesting that we feel bad for a particular hedge fund. According to Forbes, Melvin Capital’s CEO, Gabriel Plotkin, earned $300M in 2017. And we know that the practices of hedge funds smack of manipulating the system. But I am suggesting that Melvin Capital was vilified for a very common hedge fund practice. There is a necessary role in our investment system to generate returns beyond what traditional investment products can provide. There’s also an urgent need to diversify (and mitigate) risk (more in the following takeaway.) And short selling is legal. We don’t feel good about it, and we don’t appreciate that both the practice and its comprehension feel inaccessible to many of us.

If this is meant to be a take-down of the hedge fund industry in the name of change, that’s a conversation worth having. But a GIF-fuelled targeting of a single fund just because? Less so.

Finally, the irony of the outsized wins of the GameStop schemers, in the name of the “average person” is almost too much. In Roose’s same piece, one of the Reddit users shared: “Greed is absolutely out of control at the top, and this funny little news story is tangible proof of that. Do not let them gaslight you into thinking that it’s wrong for you to get a slightly larger sliver of the pie.”

According to the same article the scheme’s originator “claims to have turned an initial investment of $50,000 into a windfall of more than $40 million.” “Slightly larger” sliver of the pie indeed. That an initial investment of $50K into a single holding just to put a clown nose on Wall Street is reflective of the purchasing power of the “average individual” — the real retail investor — is deeply out of touch.

Hedge funds manage our money too

The rallying cry of this effort by its perpetrators was to “fight for the little guy” — the typical individual investor who is shut out of a mostly accreditation-driven investment market. The effort to democratize access to the investment universe is an important cause. One deeply worth fighting for. And it is true that individual investors have fewer opportunities to use hedge fund tricks — like speculation. But the idea that a scheme of this nature hurts the hedge funds themselves — instead of us, the people — demonstrates a deep lack of understanding of the cyclicality of markets.

The primary investors in hedge funds are institutional investors — professional investors who manage large amounts of assets on behalf of others. Pension funds, sovereign wealth funds, and insurance companies are a few of the more popular examples. And where do they get the assets that they manage? Us. Employees. Governments. Policy holders.

Pension funds, a key investor for hedge funds, are employer-sponsored funds (or plans) that provide retirement income for employees. That income is generated by investing plan contributions and using returns to satisfy the plan’s obligations (read: payouts) to its pensioners. The average plan in the U.S has a return target of 7–8%. In the United States, data from The Pew Charitable Trusts suggests that the pension funding gap — the distance between “a retirement system’s assets and liabilities” — is $1Tr. Trillion. For 20 states in the nation, the amount of plan funding available dipped to an average of 57% in 2017. The demand for payouts far surpass the assets these plans have to give. (One of the reasons for this is the changing nature of work — people are moving away from the types of jobs where pensions are offered, and towards private companies that don’t offer the benefits or more entrepreneurial careers. The result is fewer people contributing to pensions than those receiving distributions.) Sovereign wealth funds (SWF), another popular hedge fund investor, are state-owned investment funds that invest in real and financial assets to generate surpluses that are then reinvested in the nation’s economy and its citizens. Aproximately 11% of the capital invested in hedge funds comes SWFs. Pension plans and SWF’s look to hedge funds for their ability to enhance those returns.

More importantly, hedge funds (when used correctly) offer the ability to mitigate risk. What happens if all our eggs are in one very unpredictable stock-market looking basket? If market performance tanks, hedge funds’ ability to cover those losses by investing in counterbets and countertrends keeps portfolios solvent.

To round out the point on who is — actually — bearing the losses of this scheme, Juliet Chung’s piece in the Wall Street Journal points out that it took only a couple of days for Melvin Capital’s existing investors — Citadel and Point72 — to invest an additional $2.75bn in Melvin Capital after the GameStop loss. This was in addition to a cumulative $3Bn they already had in the fund. Hurt the hedge fund, Men in Tights, you did not.

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I’m not suggesting that hedge funds deserve our sympathy. Nor am I suggesting that they are not sometimes inaccessible, extractive and just plain dirty. In 2008, the criminal activity of the Galleon Group, and it’s founder Raj Rajaratnam, was an important example of the system-wide havoc that this deeply exclusive and entitled world can wreak. And short sellers do profit from the misery of others — companies hate being targeted by short-sellers (and who wouldn’t? The public vote of unconfidence is demoralizing.)

But this “vengeful nihilism” as author Martin Gurri describes, allows for the dismantling of institutions before we’ve really contemplated how to rebuild them. For those of us in impact investing (an investment approach that encourages making investment in line with your values, with the intention of generating both financial and social/environmental returns), this is an unhelpful course of action.

We have to accept that our current interconnected nature — particularly within the capital markets — means that individuals and institutions graze on the same lands (even if not in equal measure.) A fund-targeted shakedown means something for the pension holders of Melvin Capital’s investors, whether losses were recovered or not. We don’t have enough transparency in the private investment market (hedge funds included) to ever know the full value of losses realized, or what actually trickles down to the fund’s investors, especially when system-shocking events like this occur. To our knowledge, Melvin Capital was buoyed by a capital infusion. But that could only be some of the story. And there are other funds out there who held a similar position — similarly shorting GameStop’s poorly performing stock — who may have taken a serious hit. We’ll never know (unless some brave investor tells us) and we have to think about all of the unintended consequences of these actions.

A tear-down at all costs approach is a short-sighted solution. Alternatively, there are things we can do — today — to start to agitate change from within the system, while simultaneously working to build back better than before:

As an individual investor, find investment products that allow you to have an intentional positive impact.

Put your dollars where your values are. Much of the recent progress in impact investing has been about using the demand for values-aligned investing to support the emergence of new products that are actually designed for us. Today, we have access to investment options that allow us to bank, save and invest differently — intentional and responsibly. You can check out this great list from CNote on retail impact investment offerings or peruse this piece we wrote with the colleagues at Change Finance, Swell Investing, and CNote about what it means to truly democratize access to investment products. (This is not an investment recommendation. Every investor should do their own due diligence and select the products that are in line with their risk, return, liquidity, and impact expectations.)

As a policy maker, push for consistent regulation of all investment actors — don’t pick and choose whose voice gets heard.

The ability for Robinhood, and platforms like it, to create pathways into the public markets for those who were previously without access is critical and important. But it comes with a massive responsibility. Accreditation rules, monitored by the Securities and Exchange Commission (SEC) in the U.S., were originally created to protect the average investor from life-altering losses. While many of us agree that this type of restriction is mostly out of date (and a little bit overreaching,) the intention is sound. We need to protect ourselves and each other.

If we look to Facebook and Twitter to claim responsibility for their platforms as a medium for misinformation and abuse, so too do we need to investigate the potential negative externalities of a platform like Robinhood. Unfettered access isn’t such a lofty goal that we should allow the threatening of the financial future of others. Individual investors and hedge funds are all investment actors — no one should be able to game the system.

And that, of course, calls for more action in how we monitor hedge funds. If — in our new version of Stakeholder Capitalism — we collectively decide that the practices of these investors no longer jives with this new system we’ve built, we have to use regulation to make these strategies illegal. And ensure that the use of illegal approaches are prosecuted. But we cannot grant legality and then punish by mob in chat forums.

There are impact investments in every asset class. As an accredited investor, you can move your money into values-driven hedge funds.

While we collectively work to rebuild the investment systems of yesterday we need to explore not only new ways of doing everything, but much better ways of doing existing things. A new class of activist (and impact) hedge funds are emerging to integrate environmental, social and governance (ESG) values and shift the way we think about creating value. Jessica Pothering’s coverage in ImpactAlpha points to two new impact hedge funds that are shifting industry norms:

• Chris James (a hedge fund veteran who started Andor Capital Management in the early 2000s) launched Engine №1 to engage its portfolio companies to invest in “workers, communities, and the environment” and align “the interests of Main Street and Wall Street.”
• And Two Sigma — a $58bn New York-based hedge fund manager has just launched Two Sigma Impact, “a private investments business focused on combining active, principled ownership and data science with the goal of delivering superior returns and positive social outcomes.”

(This is not an investment recommendation. Every investor should do their own due diligence and select the products that are in line with their risk, return, liquidity, and impact expectations.)

Whether these managers actually design products for impact or will be the latest in a long list of impact-washers remains to be seen, but the point here is we will see. With massive leaps forward in the development and use of impact measurement and management frameworks, investors should feel empowered to ask questions, demand proof, and raise a flag when things don’t feel right.

This is also an opportunity for asset managers to rethink increasingly outdated approaches to portfolio construction. Are the inclusion of hedge funds actually providing outsized revenue? (Industry consensus is no, not as much as they used to.) If we need diversification and to mitigate correlation are there other ways to do that? If we’re rethinking some of our norms, now is a good time to rethink all of them.

In the end, our biggest learning from all of this is that the seductive narrative of “sticking it to the evil suits on Wall Street” can mistakenly lead us to forget that we are part of that system. Wall Street serves us. The real innovation in this David vs. Goliath saga is that the system can be interrupted. There are ways that inviduals can engage, disrupt, and change the status quo. And that, in and of itself, is noteworthy. But the intention behind those actions are not only short-term, but they lack the values-driven decision making we need to see in our investment ecosystem moving forward.

There is no doubt that we have to rebuild the investment universe better than it is now. The current system has historically ignored and excluded many voices — the underbanked, whole communities, and many many places. Our patience for this exclusion has run its course. But we can resist tear-down culture and use our unique position as true constituents of this system to rebuild it — better than ever.